Opportunities: The Most Important Venture Capitalist

In this column, I discuss the VC process from an unusual perspective: getting your venture funded with government research and development (R&D) dollars. It turns out that your years spent writing and managing proposals for research funding have prepared you well for financing your venture without needing to worry about the VC industry. There’ll be plenty of time to hang out with VC celebrities later, if things go well. For now, let’s stick with a modified version of the tried and true.

Seed-stage funding for your venture

Although generating and ruminating over business ideas doesn’t cost anything, actually DOING something to make those ideas a reality requires financial resources of one kind or another. This is particularly true with start-up ideas based on technology. As you know from years of doing science, to make technical progress on a good idea you need facilities and the right equipment.

Although it may be possible to perform experiments or technology development at a small scale in the corner of your or your adviser’s laboratory, it isn’t wise to do this for very long. As discussed in a previous column, if you work at a university, government laboratory, or company, your employer or host may end up with the rights to your good idea. For this reason alone, it is often critical to set up a private R&D operation. And this is where you’ll need money–potentially, a LOT of money.

Venture capital provides the funding you need to develop that good idea. In the case of a technology-based start-up, it enables you to build the R&D infrastructure necessary to turn the idea into a business. “Private” venture capital is, as its name suggests, private capital, usually provided by a group of investors through a VC fund, which is invested in early-stage ventures.

Private venture capitalists make investments in exchange for a piece of your venture–often a big piece. It is not uncommon for an entrepreneur to give up a third of the equity in his or her company in the first round of financing. Further rounds dilute an entrepreneur’s equity even more. Members of the founding team may end up with less than 10%–collectively–of the shares in a company they started, and sometimes it’s a lot less.

There is another problem with private VC investments in early-stage technology ventures. From the venture capitalists’ perspective, the ideal investment is in a company that will be acquired or will undergo an IPO within 3 years. It is rare for an early-stage technology venture to grow that fast, and force-feeding it is often fatal. For these reasons, private VC investments in early-stage technology ventures are rare and tend to be clustered in “hot” technology sectors. For the past 5 years, nanotechnology has been hot, but this is giving way to the latest “hot” areas: energy and (more broadly) green technology.

The paucity of VC investment in early-stage technology ventures practically requires technology entrepreneurs to find other ways to build their companies. And this is where Uncle Sam steps in. Government grants for technology-based businesses are very similar to those you might win in academia, but because they are given to small businesses, there is an added focus on technology commercialization.

The pluses and minuses of “public” venture capital

Government R&D funding for technology development in a start-up comes with advantages and some disadvantages. The most obvious advantage is that Uncle Sam does not demand a fraction of your company in exchange for the money, so your share of the company is not diluted. Another advantage is that government agencies that “invest” in R&D tend to take the long view: They understand that revolutionary technologies might take a decade or longer to mature and that it’s worth the wait.

One more important (and underappreciated) advantage of government funding is that the government is itself a potential customer for your technology and the products that embody it. If a government agency helps fund the development of a technology, it is often because it needs it itself. When you receive federal funding for your start-up, you get to meet and interact with program managers and procurement directors who buy the products you plan on making. This can be valuable “customer development” for an early-stage start-up.

But government funding for technology development in a start-up is not without drawbacks. For starters, many more proposals are submitted than get funded (although the Small Business Innovation Research managers I have spoken to say that the odds for high-quality proposals getting funded are very good). Such R&D money doesn’t support marketing, sales, or the many other critical activities an early-stage business must engage in to survive, so it’s very hard to sustain a commercial enterprise solely on government R&D support. Still, such support can provide the financial backbone for a company at an early stage.

But the biggest problem with government funding for an early-stage start-up is that it is sometimes hard to completely align the goals of the government-funded research program with the commercialization goals of the company. Often, the government agency defines the fields of interest and eligibility for funding based on its needs and not the needs of the marketplace.

Taking government R&D money to develop your technology can steer your company’s technology development in a direction in which the ultimate commercialization opportunities are limited. Furthermore, although the government often funds new areas of technology, there are plenty of areas of technology that the government doesn’t fund. And thanks to the current Administration, there are a few very promising areas (such as stem cell research) in which funding is restricted for political reasons.

Any source of funding for your start-up should be examined for its strategic value. Private venture capital can unlock a range of new opportunities, from recruiting top managerial talent to accessing further investment. Corporate investment can usher in the possibility of strategic partnership and a channel for product development and sales (and an eventual acquisition). But I have found that for an early-stage, technology-intensive start-up, government funding can nicely complement a seed-stage equity investment, reducing the equity dilution to the founders, increasing the capital available for commercialization, and providing critical leverage that neither source of funding could provide on its own.

In the coming months, I will discuss some of the specific mechanisms and programs that exist at the federal level to support R&D in small companies. These programs can be a critical source of support for you as your early-stage venture gets off the ground. Stay tuned!

Image: Middle, Comstock Business Impacts

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